Direct indexing has been a tax savvy investment strategy used by the wealthy for a long time. The recent birth of commission free trading and advancement of trading technology has made it more widely available and applicable to all investors in today’s market.

When you hear the term index in the investment world, you might think of an ETF or index fund that carries a low cost expense ratio and gives you access to a diversified basket of stocks, such as the S&P 500. These index funds give you the ability to own a slice of all 500 stocks by purchasing one security and are a cost effective way to gain investment exposure to the largest companies in the US.

Direct indexing achieves the same goal of passively investing in an index of companies, but instead of owning one security you own all of the securities in the index. To learn more about the intricacies of how Direct Indexing works, I found this article by Morningstar to be a helpful resource. This strategy provides investors with benefits such as reducing concentrated stock positions and customizing stock selection, but the purpose of this article is to showcase the tax benefit.

In the chart below you will find a real life example of tax loss harvesting from our use of direct indexing with clients in 2023. We implemented this strategy for a handful of clients that were in a high tax bracket (we consider 32% or greater to be high) and had more than $100k in a taxable brokerage account.

This account was funded on June 22nd and as you can see the performance mimics that of the S&P 500, which is what it is designed to do. The benefit of owning all of the stocks in the index is the ability to sell the companies that suffer losses throughout the year to realize the capital loss for tax purposes. Of the 500 companies in the index, 179 of them posted a loss in 2023, even though the index as a whole posted a positive 26.29% return (with dividends reinvested).

As you can see below, the losses taken throughout the year account for an 8.59% loss for tax purposes, when in reality the account gained 9.45% in value. These losses can be used to offset gains from other investments, reduce ordinary income by $3,000, or be carried forward for future use.

You might be thinking this is too good to be true…what’s the catch? The catch is that you will have to pay tax on the capital gains at some point when you ultimately sell the investments. With effective tax planning, we believe that this presents an opportunity to pay a potentially lower tax rate on those gains as well as take the tax break when your income is high. Here are a few scenarios when we would help a client realize those gains at a lower rate if they:

• plan on taking time off after selling company stock

• have more income than needed in retirement from Social Security, Pensions, and IRAs

• are charitably inclined and are able to gift securities to a Donor Advised Fund

• plan on leaving money to your heirs

• find yourself in a high tax bracket due to a bonus, company buyout, or windfall

Under the current tax laws, there are certain situations or opportunities that allow you to pay 0% in tax on those capital gains if held for more than 1 year (long term capital gains). Two quick examples include:

• If you have no other earned income, the tax on your long term capital gains will be 0% until you hit $89,250 in AGI if married filing jointly ($44,625 if Single) as of 2023 tax law.

• If this brokerage account is a part of your gifting / estate plan, your heirs will also pay 0% capital gains tax upon the transfer of assets.

As you can see, the timing of tax payments in coordination with certain life events / time periods is what makes tax planning both challenging and valuable. Under the current tax laws, there are a number of opportunities to reduce your tax liability while working in addition to reducing tax liability in the retirement phase of life.

This strategy might not benefit you right now, but as one continues to build wealth by investing in a non-qualified brokerage account, it is worth considering. If you have questions on whether or not this could benefit you, feel free to book some time with us.